The
Great Debate!

Puru Saxena
14 Nov, 2005

The entire investment community
seems to be obsessed with the appointment of Ben "Helicopter"
Bernanke as the new Chairman of the Federal Reserve. "What
will the new maestro do? Will he continue to raise interest-rates?
Will he target inflation? How will the markets react?" Such
questions have been popping up almost everywhere. I am going
to address some of these issues but first, let me explain the
key concepts of inflation and deflation.

The widespread belief is that
the Federal Reserve is currently increasing interest-rates to
"control" inflation. This misconception stems from
the fact that most people don't really understand inflation.
The great majority think that inflation is an increase in the
prices of goods and services, which is totally incorrect! In
actual fact, inflation is defined as an increase in the quantity
of money. A general increase in prices is merely a consequence
of inflation. An over-supply of money (inflation) causes its
value to drop and it takes more money to buy the same quantity
of goods and services, causing prices to go up.

In addition to this, the consensus
is that deflation is a fall in the prices of goods and services,
which is also inaccurate! It is crucial to understand that deflation
is in fact a decrease or contraction in the quantity of money.
A general decline in prices is merely a consequence of deflation.
A reduction in the supply of money (deflation) causes its value
to rise and it takes less money to buy the same quantity of goods
and services, resulting in lower price levels.

The fact that the public does
not understand inflation or deflation allows the central banks
to carry on with their money printing agenda. All this while,
the public remains oblivious.

The Federal Reserve was established
in December 1913 and its objective was to "control"
inflation. Well, I hate to break this to you but the Federal
Reserve has failed in its task of "controlling" inflation.
In fact, the US dollar has lost 95% of its purchasing power through
money printing (inflation) since the Federal Reserve came into
power. In other words, the $1 your ancestors saved for you in
1913 is only worth 5 cents today! This is an outright confiscation
of hard-earned savings.

Take a look at Figure 1, which
shows that consumer prices remained flat throughout the 19th
century. Consumer prices only started to go up after the Federal
Reserve came into power in 1913. It is interesting to note that
money lost most of its purchasing power after gold was removed
from the monetary system in 1971. Once the Americans made gold
redundant, the central banks were allowed to print as much money
as they wanted since money was no longer backed by a tangible.
And print money they did! This reckless printing of money is
the reason why things have become so unaffordable for most people.

The grim reality is that the
modern day central banking IS inflation and the quicker you get
used to this idea the better. The deflation scare is nothing
more than a decoy, which the central banks use in order to continue
with their money printing (inflationary) program. Still not convinced?
Then, consider the greatest fabrication, the Japanese "deflation"
scare.

For years now, we have been
told repeatedly that the root cause of Japan's economic problems
is deflation. We have been forced into thinking that deflation
is the culprit. Allow me to share a secret - the central banks
want you to believe that deflation is a total disaster so that
they can freely print more money, thereby creating inflation.
After all, who benefits from the monetisation of the economy?

Despite all the brainwashing,
close inspection reveals that Japan never really had any deflation!
The truth is that throughout the past 15 years, Japan's money
supply has continued to grow (inflation). Figure 2 clearly shows
that Japan has witnessed inflation and not deflation since 1980.
Sure, Japanese asset prices have fallen since 1990 but the cause
is not deflation as advertised by the establishment. In fact,
a sharp rise in interest-rates was the trigger, which caused
the Japanese stock and property bubbles to burst.

These days, we are being told
that the Federal Reserve is raising interest-rates to "control"
inflation. If the Federal Reserve was really curbing inflation,
why would the American money supply continue to surge despite
recent interest-rate hikes? Despite all the noise about inflation,
the Federal Reserve has added roughly US$1 trillion to the system
over the last year! So, on one hand the Federal Reserve continues
to inflate and on the other hand it is raising rates. "But
why would it do that?" you may ask. You see, the US economy
is in a mess and a true contraction in the money supply (deflation)
would send the whole world into a severe recession. Under this
scenario, millions of companies and individuals would go bust
and the entire financial system may collapse. Therefore, you
can be rest assured that the Federal Reserve will continue to
inflate for as long as possible. Take a look at Figure 3, which
shows the relentless growth of money supply (inflation) in the
US. It is shocking to note that the broad-based money supply
(M3) has increased from US$ 6.5 trillion to US$10 trillion in
5 years - representing a 54% increase! Yeah, Greenspan did a
fine job "managing" inflation!

As far as the current situation
is concerned, I believe the Federal Reserve is raising interest-rates
to prevent an outright collapse of the US dollar. A weak currency
needs to offer a high yield (interest) in order to attract capital.
Indonesia, Russia, Brazil and Venezuela come to mind. Today,
the US is the world's largest debtor nation and its current account
deficit stands at US$ 730 billion or 6.3% of GDP! Students of
economic history know that no other country or its currency has
ever managed to get away with such economic murder. You can be
rest assured that it is obvious to both Greenspan and Bernanke
that the US dollar is skating on very thin ice. In an attempt
to rescue the situation, interest-rates in the US are being pulled
up to increase the demand for dollars.

In my view, interest-rates
in the US will rise much higher than most people expect at this
time. If history is any guide, Mr. Bernanke will continue to
inflate the money supply whilst increasing interest-rates over
the coming months. Already, he has talked about dropping dollar
bills from helicopters. Well, at least the guy is honest!

Puru Saxena publishes Money Matters, a monthly economic report, which highlights extraordinary investment opportunities in all major markets. In addition to the monthly report, subscribers also receive "Weekly Updates" covering the recent market action. Money Matters is available by subscription from www.purusaxena.com.

Puru Saxena is the founder of Puru Saxena Wealth Management, his Hong Kong based firm which manages investment portfolios for individuals and corporate clients. He is a highly showcased investment manager and a regular guest on CNN, BBC World, CNBC, Bloomberg, NDTV and various radio programs.